Contributions to investors’ protection fund and the fraudulent preference risk

 Investors’ Protection Fund is a quasi-insurance scheme which securities exchanges and capital trade points in Nigeria are required to set up pursuant to section 197 of the Investments and Securities Act, 2007. The primary aim of investors protection funds is to compensate investors who suffer financial losses resulting from (i) insolvency or negligence of any dealing member firm, and (ii) embezzlement of securities, money or property in the custody of any dealing member firm or any of its directors, officers, employees or representatives in relation to securities, money or property in the course of its business as a capital market operator: sections 198, 204(a) and 212(b) of the Investments and Securities Act, 2007. In 2012, the Nigerian Stock Exchange (NSE) created its investors protection fund with a seed capital of about NGN625 million.

There are eight sources of funds for an IPF, one of which is monies by dealing member firms: sections 202(a) and 209 of the Investments and Securities Act, 2007. Accordingly, Rule 3.02 of NSE’s Investors Protection Fund Rules 2013 (IPFR) requires dealing members to contribute (i) NGN1 million prior to the acquisition of a dealing membership license, (ii) NGN1 million prior to a dealing member firm’s acquisition and (iii) an annual premium. Dealing members may also be levied where there is deficiency of funds in the Investors Protection Fund.

Insolvency law’s rule against fraudulent preference

The rule against fraudulent preference under section 495 of Companies and Allied Matters Act, 2004 (CAMA) and section 46 of the Bankruptcy Act, 1979, aims at reversing transactions between an insolvent company and a creditor which were effected within three months prior to the commencement of formal insolvency proceedings, with a view to preferring the creditor. Accordingly, for a transaction or payment to constitute a fraudulent preference, the following factors must be established: (i) a factual preference, (ii) the preference must have been given with a view to prefer the creditor, and (iii) the preference must have been given within three months before the commencement of formal insolvency proceedings.

The rule against fraudulent preference re-enforces the well-established pari passu principle of insolvency law which is to the effect that similarly situated creditors must be treated equally. The rule against fraudulent preferences also plays an anti-deprivation role by preserving the assets of insolvents from diminution. Given that the rule operates retrospectively, preferential transactions which are not vulnerable at the time they are made may become tainted by a subsequent commencement of formal insolvency proceedings. Conversely, in the absence of formal proceedings, such transactions will remain valid and enforceable.

Contributions to Investors Protection Fund in the vicinity of insolvency

Where contributions are made by a dealing member firm to the Investors’ Protection Fund within three months prior to the commencement of the dealing member firm’s insolvency proceedings, such a contribution will clearly constitute a “factual” preference. The rule against fraudulent preference does not invalidate mere factual preferences but preferences actuated with a view to prefer a creditor or group of creditors: Sharp v Johnson (1899) AC 419 at 421. In the case of New, Prance & Garrard’s Trustee v Hunting (1897) 2 QB 19 at 27, the word “view” in section 48 of the old English Bankruptcy Act 1883 (which is similar to section 46 of the Nigerian Bankruptcy Act, 1979) was equated with “intention” or “object.” Accordingly, to establish fraudulent preference, it has to be shown that the intention or object of a payment, transfer or transaction was to place the creditor in a better position than it would have been in an insolvent winding up proceedings.

Under section 198(a) of the Investments and Securities Act, 2007, one of the two objects of the Investors’ Protection Fund is expressed as being to compensate investors who suffer pecuniary loss arising from the insolvency of a dealing member firm. This clearly constitutes a preferential treatment of those investors who are indisputably unsecured creditors. Instructively, it is inconsequential that payment is not made directly to investors. It suffices that investors are the ultimate beneficiaries, and the insolvent dealing member firm has “suffered” (i.e. permitted) the payment from its estate.

Assets in the Investors’ Protection Fund are to be kept in a separate bank account pending investment: section 203 of the Investments and Securities Act, 2007, Rule 3.03 of IPFR. It appears that this provision seeks to create a trust so as to ring-fence and protect such funds. However, it is highly doubtful if this trust can effectively shield contributions made to an Investors’ Protection Fund where the contributing dealing member firm is in the vicinity of insolvency. First, the monies contributed to the fund will be from the insolvent dealing member firm’s estate. Second, the rule against fraudulent preferences under section 46(1) of Bankruptcy Act 1979 covers payments in favour “of any person in trust for any creditor.” It is suggested that the trust device would have been more effective (at the commencement of insolvency proceedings) if dealing member firms were required to pay monies received from investors into the separate bank account. In this latter scenario, the investors would be (regarded as) beneficiaries of the trust and not creditors: In re Kayford Ltd (1975) 1 WLR 279 at 281.

Conclusion

Investors’ Protection Funds have the potential of boosting investors’ confidence and accelerating the growth of Nigeria’s capital market. However, a contribution by a factually insolvent entity may constitute fraudulent preference with the consequence that such payment may have to be disgorged for the benefit of the general body of the dealing member firm’s creditors. As part of ongoing efforts towards revising Nigeria’s insolvency laws, the Business Recovery and Insolvency Practitioners Association of Nigeria (BRIPAN) has recommended for an increase in the vulnerable preference period from the present three months to six months for non-connected persons, and two years for connected persons. If this recommendation is implemented in a revised legislation, it will increase the risk of contributions to Investors’ Protection Fund constituting fraudulent preferences. Accordingly, as is the practice in some jurisdictions, policy/lawmakers need to consider expressly excluding important capital market rules, transactions and arrangements from the ambit of our insolvency law. This will ensure certainty of these transactions and obviate the need for future and unnecessary litigations over these issues. A proactive legislative intervention will also safeguard the validity of capital market arrangements, prevent systemic risks and enhance efficient functioning of Nigeria’s capital market.

Dr Kubi Udofia

Dr Kubi Udofia is an insolvency law expert and the Head of Corporate and Commercial Law Practice Group at Fidelis Oditah & Co.